About Mutual Funds

Closed-end funds

Put simply, a closed-ended fund is a collective investment portfolio that raises a fixed amount of capital through an initial public offering (IPO). A closed-end fund is called so because it is rarely that new shares are issued once the fund is launched, and because shares are not normally redeemable for cash or securities until the fund liquidates.

Typically an investor can acquire shares in a closed-end fund by buying shares on a secondary market from a broker, market maker, or other investor as opposed to an open-end fund where all transactions eventually involve the fund company creating new shares in exchange of either cash or securities or by redeeming shares for cash or securities. The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the NAV per share. The market price of a fund share is often higher or lower than the per share NAV: when the fund's share price is higher than per share NAV it is said to be selling at a premium; when it is lower, at a discount to the per share NAV.

Despite the name similarities, a closed-end fund has little in common with a conventional mutual fund, or technically an open-end fund. A closed-end fund raises a prescribed amount of capital only once through an IPO by issuing a fixed number of shares, which are purchased by investors in the closed-end fund as stock.

Unlike regular stocks, closed-end fund stock represents an interest in a specialized portfolio of securities that is actively managed by an investment advisor and which typically concentrates on a specific industry, geographic market, or sector. The stock prices of a closed-end fund fluctuate according to market forces (supply and demand) as well as the changing values of the securities in the fund's holdings.

Equity Funds

An equity fund or stock fund is a mutual fund that invests mainly in stocks and can be managed both actively and passively. It invests pooled amounts of money in public company stocks. Managers of equity funds use different methods to choose stocks while making investment decisions for their portfolios. While some fund managers use a value approach to stocks by searching stocks of companies that are undervalued in comparison to other similar firms, others choose them in terms of growth of a fund. In the latter method, stocks that are growing faster than their competitors or the market as a whole are chosen.

There is yet another class of other fund managers who buy both kinds of stocks and build a portfolio of both growth and value stocks. Since equity funds invest in stocks, they are potentially high-returns yielding funds but carry greater risks at the same time.

Choosing an equity fund: comparison matters

A key basic of benchmarking is the evaluation of funds within the same category. For instance, if prospective investors are assessing the performance of information technology (IT) based fund, they should first compare its performance with a similar IT based fund. Comparing it with funds from another sector like the banking sector will not provide the accurate picture. Comparing a fund over a stock market cycle (highs and lows) can also provide investors a good understanding about how the fund has performed.

Compare returns against a benchmark index

Every fund provides a benchmark index in the Offer Document. In the case of India, these benchmark indices could be BSE 100, BSE 200, Nifty or other indices. Both the fund manager and the investor can rely on the benchmark index as a guidepost and compare the fund's performance against the benchmark index over a period of three to five years. Funds that have performed better than their benchmark indices during stock market volatility deserve a closer look. Investors should also evaluate the fund's historical performance for getting an idea about consistent performers.

Exchange- Trade Fund

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges on real-time basis, in a similar fashion as stocks of companies are traded. ETFs, hence, also emulate the nature of a stock market index in that they hold securities. Most ETFs track an index, such as the Standard & Poor's (S&P) 500 , a commodity or other various assets similar to an index fund. Some of the unique features of exchange-traded products are that they come at affordable prices and are tax efficient. Because it trades like a stock, the net asset value (NAV) of an ETF is not calculated every day as in the case of a mutual fund.

The functioning of an ETF

In the case of normal funds, an investor buys and sells units directly from or to the fund manager. The money is first collected from the investors to form the corpus which is used by the fund manager corpus to build and manage the appropriate portfolio. Whenever and investor wants to redeem his units, a portion of the portfolio is sold and gets paid for those units.

Role of institutional investors

The units in a conventional mutual fund are called 'in-cash' units. However, in case of ETFs, there are 'authorized participants' or institutional investors appointed by a fund manager.

Institutional investors are organizations such as banks and insurance firms which pool large sums of money and invest them in investment assets. They will first deposit all the shares that comprise the index with the fund manager and receive 'creation units' from it. Since these units are created by depositing underlying shares, they are called 'in-kind' units.

These creation units can be large blocks of tens of thousands of ETF shares, which are subsequently formed into smaller units and the authorized participants buy or sell them accordingly in the open market on the stock exchange.

In this way, every buy and sell technically need not change the corpus of an ETF unlike a conventional mutual fund.. But if there is more demand, the authorized participants deposit more shares with the fund manager and get more creation units to satisfy the demand. Or if there is more redemption, then they give back these creation units to the AMC, take back their shares, sell them in the market and pay the investor.

Mutual funds – a brief introduction

Generally speaking, mutual funds are collective investment schemes which are also called investment funds or managed funds. Money, when invested collectively by pooling it from a number of investors, facilitates each investor to participate in a wide range of investments than would be possible in an individual capacity.

Role of a mutual fund manager

Mutual funds are managed by professionals who buy various types of collective investment securities -- namely, stocks, bonds, unit trusts, commercial paper, bankers' acceptances, real estate and precious metals. Of these, stocks and bonds are considered to be the most common investment securities to be traded in the market. While stocks represent shares of ownership in a public company, bonds represent the money that a person lends to the government or a company, and, in return, receives interest over a predetermined period of time on the amount lent.

A mutual fund has a fund manager who is responsible for investing the collected money into such securities. The mutual fund managers help individual investors manage their funds, take care of accounts and invests money over a myriad available securities.

It must however be remembered that when investing in a mutual fund, investors places their money in the hands of a professional manager. The return on investments depends heavily on that manager's skill and judgment. As research has shown that few portfolio managers are able to outperform the market, a person must check the fund manager's track record over a period of time when selecting a fund.

It follows from the fact that a person investing in a mutual fund is the buyer of units or portions of the fund, and hence becomes a shareholder or unit holder of the fund.

Nature of mutual fund schemes

In 1963, when the Unit Trust of India was formed, the evolution of the Indian mutual fund industry started. Currently, there are hundreds of mutual fund schemes that one can invest in. However, it is easier to place them in categories.

Open-ended and close-ended schemes

The open-end mutual fund category is available for subscription throughout the year and does not have a fixed maturity. The key feature of an open-end scheme is liquidity, which gives a fund investor the opportunity to buy and sell shares at prices related to their net asset values (NAVs) -- a fund's per share market value.

The close-ended scheme has a predetermined maturity period – usually ranging from 2 to 15 years in India and a person can invest directly in the scheme during its launch.

Interval options

Generally speaking, mutual funds are collective investment schemes which are also called investment funds or managed funds. Money, when invested collectively by pooling it from a number of investors, facilitates each investor to participate in a wide range of investments than would be possible in an individual capacity.

Benefits for investors

There are three ways by which mutual funds return benefits to investors. Firstly, income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all income it receives over the year to fund owners in the form of a distribution.

Secondly, if a fund sells securities that have gained price, the fund has a capital gain, and most funds pass on these gains to investors in a distribution. Thirdly, if fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. Investors can then sell their mutual fund shares for a profit. Funds will also usually give an investor the choice to either receive a check for distributions or to reinvest the earnings and get more shares.

Benefits for investors

There are three ways by which mutual funds return benefits to investors. Firstly, income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all income it receives over the year to fund owners in the form of a distribution.

Secondly, if a fund sells securities that have gained price, the fund has a capital gain, and most funds pass on these gains to investors in a distribution. Thirdly, if fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. Investors can then sell their mutual fund shares for a profit. Funds will also usually give an investor the choice to either receive a check for distributions or to reinvest the earnings and get more shares.

Open-end funds

Open-end funds are the most popular variants of mutual funds. Put simply, open-end funds refer to the flexible corpus of mutual funds which allows an investor to buy the shares at any point of time and make a voluntary exit from it. Some of the key characteristics of open-end funds are as below:

Flexibility

Open-end funds thereby do not have restrictions on the amount of shares the fund will issue. If demand is strong, the fund will continue issuing shares irrespective of investor numbers. Reversely, open-end funds also allow investors to buy back buy back shares when investors wish to sell. Usually, an investor purchases shares in the fund directly from the fund itself and not from existing shareholders. Given the flexibility in the sale and purchase of fund shares, open-end funds have become a convenient investing vehicle for mutual fund investors.

Affordability

The popularity of open-end funds is also in terms of its affordability. For instance, a person who cannot afford high initial prices can purchase funds with low dollar values and on a monthly basis.

NAV-driven share price

Ideally, when a fund's investment manager determines that a fund's total assets have become too large to effectively execute its stated objective, the fund will be closed to new investors and in extreme cases, be closed to new investment by existing fund investors. The price at which shares in an open-ended fund are issued or can be redeemed will vary in proportion to the net asset value (NAV) of the fund, and therefore, directly reflects the fund's performance.

Net asset value or the on a particular date reflects the realizable value that the investor will get for each unit that he his holding if the scheme is liquidated on that date. It is calculated by deducting all liabilities (except unit capital) of the fund from the realizable value of all assets and dividing by the number of outstanding units. Furthermore, new investors can join open-ended schemes by directly applying to the mutual fund at applicable NAV related prices. Net asset value on a particular date reflects the realizable value that the investor will get for each unit that he his holding if the scheme is liquidated on that date. It is calculated by deducting all liabilities (except unit capital) of the fund from the realizable value of all assets and dividing by the number of outstanding units.

Get Going with Mutual Funds


To appreciate the concept of Mutual Funds, it's important to grasp the essence of Pooling. Let's do that through everyday examples. When many people come together to contribute to a common fund driven by a common purpose, they are said to be "pooling" together. The reasons could be diverse - from buying gifts and hosting parties to raising money for social commitments or making investments.

A Mutual fund is a collective investment that allows many investors, with a common objective, to pool individual investments that are given to a professional manager who in turn would invest this money in line with the common objective. The manager is a highly qualified investment professional with rich relevant experience. He develops investment strategies after detailed market analysis and manages day-to-day portfolio trades. In doing so, he ensures:
  • Professional management: Focused & dedicated fund manager & well-equipped research team
  • Convenience: Easy investment & withdrawal, minimal paperwork and online transactions
  • Diversification: spread-out portfolio across companies and industries to maximise gains and minimise value erosion
  • Liquidity: Buying and selling through stock exchanges and direct MF withdrawals
  • Tax benefits: Section 80 C exemptions up to Rs 1 lakh, tax-free dividends, no long-term capital gains for equity MFs
The flow chart below explains how Mutual Funds operate:

This operation of course is carried out under the aegis of a structure that's made up of the following constitutional hierarchy:


Here're few key terms from the MF world:

New Fund Offer (NFO): The initial period offer made of fixed price units when a new scheme is launched by a fund house.

Net Asset Value (NAV): Total value of portfolio LESS liabilities DIVIDED BY number of outstanding units. NAV is calculated on a daily basis.

Load: charge on the NAV calculated as a percentage of NAV governed by SEBI regulation and subject to industry practice.

An Entry load* increases the sale price for the purchasing investor. To buy units of a MF scheme with NAV Rs. 10 and entry load of 2.25 per cent, the investor would shell out

10 + (10*2.25/100) ie. Rs. 10.225

An exit load reduces the repurchase price for the selling investor. To sell units of a MF scheme with NAV Rs. 10 and exit load of 2.25 per cent, the investor would get a price of

10 – (10*2.25/100) ie. Rs. 9.775

*With effect from August 2009, Entry loads on MF schemes have been removed.